A Non-normal Model of Price Movements and Risk Management Taylor Trott I.

Introduction Stock prices may appear to be purely random processes with no patterns and no predictability. And more often than not, people unfamiliar with stochastic processes will equate the work of financial engineers with "hocus-pocus," "rocket science," or gambling. Are these people correct? Are asset managers playing roulette with the public's money? f so, then the life work of t!, "erton, #lack, Scholes, $ull, %o&, 'arrow, (hite, $eath, and others amount to no more than speculation. Assuming otherwise ) that there is method to the madness of these famous thinkers ) prices are predictable* and stochastic calculus pro+ides a framework with which to build these predictions. #ut how accurate and reliable are these frameworks? $ow can we use predictability to properly manage risk? ,a-, .&pected Shortfall, and .&treme ,alue are /ust a few methods to manage risk. (hile these methods may pro+ide decent forecasts 012 of the time, what about the 12 of time they fail? n fact, these times of failure are the times which cause the most damage to a financial system. (hy do they fail? 3heir assumptions are incorrect. 3he reason they fail is because they ha+e an innate inability to model the fundamental mechanisms at work in a financial market. nstead, a better risk measure should be based on a fundamental system approach. 3he financial market is a network of agents in constant flu&. 3hese agents e&change assets. t is the constant +olume of asset e&change which creates the price changes seen by market statisticians. 4nderstanding agent beha+ior and the interactions of the entire network pro+ides a fundamental approach to manage risk. An agent approach to manage risk may better prepare risk managers for the 12 of times when their models fail. f risk managers belie+e that asset prices are predictable in the near or long term, then we must assume that there is an underlying structure. 5or e&ample, consider the science of predicting .arthquakes. 3he fact that we e+en try to predict their occurrence suggests that we ha+e some degree of knowledge regarding their underlying structure. #y belie+ing in the predictability of price tra/ectories, we naturally assume some underlying structure. #ut what is this structure? $ow do we monitor the processes at work? "ost practitioners assume this underlying structure to be a (iener 6rocess. s this a correct assumption? 3he accuracy of the forecast depends greatly on the assumptions made regarding the structure of the price process. 3he ma/ority of models assume7 8. 3hat returns are independent in time. 9. 3hat +olatility is constant. :. 3hat markets are efficient. ;. 3hat prices follow the <eometric #rownian "otion 1. 3hat there are no transaction costs =. 3hat there are no /umps >. 3hat prices sequences are "arko+ 6rocesses ?prices are memory-less@ n other words, most models assume that human emotions, psychology, and beha+ior are not factors in determining the price tra/ectories of assets. $ow can such critical factors be ignored by financial engineers? 3he number of papers dealing with the effects of beha+ior on stochastic equations are few. nstead, the academic community has, and continues to, brush off these factors with the wrongly conceptualiAed idea that the sum total of all human interactions is analogous to #rownian "otion. 3he statistics and equations of heat are what inspired the creation of the (iener "easure. So, the question is7 %an we equate the processes which follow #rownian "otion to the properties of asset price

mo+ements? Bne is created through the random thermal interactions of billions of molecules* the other through human emotion, psychology, and beha+ior. -isk managers should realiAe these assumptions and they should be cautious. II. A New Model Are returns predictable? According to research on historical data, the answer to this question is a firm yes. #ut arbitrage theory says that such predictability does not e&ist. (hat does the risk manager do to manage hisCher portfolio? Does heCshe belie+e that prices are #rownian "otions* that the markets are efficient machines* that prices are not affected by the emotions, psychology, and beha+ior of humans* or does heCshe disregard these assumptions in fa+or of the historical data, which indicates that these ideas are incorrect? 3he answer to this question lies in contro+ersy and may not be resol+ed for a long time. $owe+er, the risk manager has 8EE billion of assets which he must manage today. (here is he to look for alternati+e models which disregard the assumptions of his colleges and predecessors? 3his paper pro+ides the beginning of one such alternati+e. 3his paper presents a stochastic model of the form7 F6 G 5?+olume@. 3he +olume depends the number of e&changes between agents. 3he price responds by mo+ing in a direction corresponding to the net ratio of buyCsell transactions. 3he intuition behind this model comes from the concept that a stock price's mo+ement should reflect the system's dynamics, which has its roots in a bi-directional "tug-of-war" between agents who are buying and selling with human emotions, psychology, and beha+ior. 'ust as in the youthful tug-of-war game, there are times when it appears that the right side has the upper hand* then, all of the sudden, the left side makes a determined effort and brings down the right side. 3hese drastic and rapid phase transitions are H=-SigmaI e+ents in the (iener 5ramework ) they occur once e+ery 8,EEE,EEE or more years. 3he #rownian price mo+ements pro+ide a decent first appro&imation. $owe+er, price processes with #rownian "otion will ne+er e+ol+e in a manner which e&plains the styliAed facts obser+ed from the actual distribution of asset returns. 3hus, to truly model price beha+ior, practitioners should study the fundamental structure of the market7 a system of interacting agents. III. Computation of Model 3ake a snapshot of all market participants in a security JKL. 3his is time Aero ?t G E@. Suppose there are a fi&ed number of agents, M, in the financial system who can own andCor trade JKL. n other words, the price mo+ement of this asset should depend e&clusi+ely on the interactions between these M agents. Mow, count the number of agents who currently hold a short position in JKL and a long position in JKL. Net SE and NE represent these agents, who are currently short and long, respecti+ely, the asset JKL. Net SE O NE P M, thus there are a number of agents, $E, who currently hold neither a short nor a long position. 3hus, $E G M ) SE ) NE. 3he current price of JKL is 6E. Assume that all transactions only e&change 8 share of JKL. 3his model can be de+eloped in the future to address the details of the situation where agents hold +arious numbers of shares. Mow consider the ne&t possible mo+es for all agents in the market ?t G 8@. 3here are assumed to be four possibilities7 8. An JKL owner with a long position sells. ?N8 G NE ) 8 and $8 G $E O 8@ 9. An agent short JKL co+ers hisCher position. ?S8 G SE ) 8 and $8 G $E O 8@ :. A neutral agent initiates a long position. ?N8 G NE O 8 and $8 G $E - 8@ ;. A neutral agent initiates a short position. ?S8 G SE O 8 and $8 G $E - 8@ 3hus, 8 and 9 increase the number of neutral agents, while : and ; decrease that number. Assume that

both 9 and : cause the price of JKL to increase by some factor and 8 and ; decrease the price of JKL by the same factor. 3hus the mo+ement of the price of JKL should be a bi-directional Htug-of-warI battle7 agents going long and shorts co+ering +ersus agents shorting and longs selling. 3o represent this computationally, a matri& can be created which holds the current state of all agents. 3o create the initial state matri&, State"atri&E, form a QM & QM square matri& ?for simplification, it would be best to choose M as a perfect square@. 3hen fill the matri& randomly with the +alue -8 representing the agents short JKL, SE. Do likewise with NE and $E, represented by 8 and E, respecti+ely. 3hus, the initial State"atri&E will be randomly filled with R-8,E,8S, representing the agents who are short, neutral, and long at time t G E. Mow, proceed one period to t G 8. 3o calculate the ne&t matri& of states, State"ati&8, do the following7 Assume that each agentTi,/U is influenced by a number, 4, of his peers and that the influence is proportional to a factor representing the general market Hmood.I %all the mood factor for the current period, "t. 3o find what the agentTi,/U will do in the transition from t G E to t G8, sum the +alues of his 4 neighbors, find their a+erage, multiply by "t and round. n addition, include a possibility for the agentTi,/U to form his own independent +alue R-8,E,8S and ignore his 4 neighbors with probability D Bt ?an idiosyncratic change of agent position@. 5or e&ample, suppose that at t G E, agentTi,/U of the matri& is short, the +alue is -8 and hisCher ; neighbors at t G E had +alues R8,E,8,-8S. Suppose the mood, "8, at this time is 8.9 and D B8 G E.9E. f this agentTi,/U does not choose an idiosyncratic position, then he mimics his neighbors. 3he sum of his four neighbors is thus Sum?agentTi,/U neighbors@ G 8 O E O 8 ) 8 G 8 and the a+erage is V. 3hus VW8.9 G E.:. -ounding gi+e a +alue of E. 3hus, the agentTi,/U should change his +alue to E in t G 8, in other words, agentTi,/U will co+er his position. 6erforming this calculation for e+ery agent on the grid will create State"atri&8. And doing this for 3 periods will create a sequence of State"atri&RtGTE,3US agent states. 3o calculate the actual price mo+ement in the transition from t to tO87 8. Sum o+er all +alues of agentTi,/U of State"atri&t 9. Sum o+er all +alues of agentTi,/U of State"atri&tO8 :. %alculate the difference, S4"?State"atri&tO8@ - S4"?State"atri&t@ and di+ide by M. "ultiply by 6t and %all this %t* thus, the change in the price o+er t to t O 8 is7 6tO8 G 6t O %t 3his will form the e+olution of the price through the states of the State"atri&RtGTE,3US sequence. Mote7 n order to make the "t factor suitable, its +alues must fall between TE,8.1@. f not, then +alues of the agentsTi,/U may be other than R-8,E,8S. 3he "t factor can be calculated at each period with the following calculation7 "t G XNt-8CXSt-8 n other words, the mood factor "t for the ne&t period is the ratio of the number of current agents who are long to the number of current agents who are short. 3here may be other ways to define this factor. I . Results As an e&ample of this model, the Illustration 1 and Illustration 2 are e&tracted from a model with the following parameters7 M G 8,EEE,EEE, 3 G >EE, 4 G ;, SE G E.;WM, NE G E.;WM, D B G E.80 G constant. . !"ample of Risk Calculation# Monte Carlo Met$od f a risk manager would like to estimate the change in +alue of his asset o+er the course of one day, heCshe could run this model 1EE times and take the a+erage final price. 3he number of periods in

each simulation would be up to the risk manager. 5or e&ample, assume that the transition to State"atri&tO8 from State"atri&t occurs e+ery minute. n one trading day ?07:E A" to ;7EE 6"@ there are :0E minutes. 3hus, the model will be ran with a sequence of State "atrices where 3 G :0E. -unning the model 1EE times with the parameters7 3 G :0E, M G 91EE, D B G E.801, 6E G Y8EE* the a+erage final price after one day is 6a+g, 3 G :0E G 8E;.80, ,ariance G ;:.=;, Skewness G 8.9Z, [urtosis G 9.;=. 3he following table shows the quantiles of the final price distribution after one trading day7 E.82 Y 01.Z8 82 Y 0=.=> 12 Y 0>.E0 912 Y 0Z.== 1E2 Y 8E9.>Z 8EE2 Y 8;8.EE

Illustration 3 pro+ides a histogram of the final price distribution. 3he histogram and the quantiles display interesting results. 912 of the outcomes are 0Z.== and below, corresponding to a one day loss of more than 8.:;2 on the notional. 3he downside of this model is the intensity of the computational comple&ity. 5or the parameters specified abo+e, the 1EE trials took more than eight hours running on a single processor. I. Conclusion 3his model, with further de+elopment, will ha+e the ability to account for the following styliAed facts of actual return distributions7 8. ,olatility %lustering 9. Mon-normal return distribution ?i.e. fat tails@ :. 'umps ;. 3he consistent appearance of chart patterns which are scale free 1. Nog-6eriodic Bscillations =. 3he effects of transaction costs 3o impro+e the model, the following ad/ustments should be made7 8. 3he ability to go longCshort more than 8 share 9. 3he dependence on any number of other agents :. A correct understanding of the idiosyncratic beha+ior of in+estors ;. nclude a bidCask order book 1. #etter algorithms to increase the computation efficiency

Illustration 1: Statematrix at t = 10. Red: Long traders, Yellow: Short traders, Orange: eutral traders! = 1,000,000

Illustration 2: Statematrix at t = 3"00. #ri$e mo%ement dis&la'ed!

= 1,000

Illustration 3: (istogram ) *inal #ri$e distri+ution o, single trading da' ) -00 trials

library?&ts@ library?6erformanceAnalytics@ library?quantmod@ Xset directory setwd?"ChomeCttrottC4buntu BneC singmodelC"@ XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Xtwo useful functions used by the code get%ord P- function?dimone,dimtwo@R &cordP-sample?87dimone,8,replaceG3@ ycordP-sample?87dimtwo,8,replaceG3@ return?c?&cord,ycord@@ S count P- function?+alue,matri&,dimone,dimtwo@ R numberP-E for ?i in 87dimone@ R for ?/ in 87dimtwo@ R if ?matri&Ti,/U GG +alue@ R numberP-number O 8 S S S return ?number@ S XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Xtotal number of traders runsP-1EE finalpriceP-matri&?E,8,runs@ for ?p in 87runs@ R dimoneP-1E dimtwoP-1E MP-dimoneWdimtwo Xtotal number of initial longs NfracP-E.; NP-MWNfrac Xtotal number of initial shorts SfracP-E.; SP-MWSfrac XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Xmatri& containing the current state of traders statematri&P-matri&?E,dimone,dimtwo@ Xcreate initial state matri& Xassign coordinates to the longs and shorts randomly for ?i in 87N@R filledP-5ANS. while?\filled@R cordsP-get%ord?dimone,dimtwo@ &P-cordsT8U yP-cordsT9U if ?statematri&T&,yU GG E@ R statematri&T&,yUP-8 filled G 3-4. S else R filled G 5ANS. S S S for ?i in 87S@R filledP-5ANS. while?\filled@R cordsP-get%ord?dimone,dimtwo@ &P-cordsT8U yP-cordsT9U if ?statematri&T&,yU GG E@ R statematri&T&,yUP--8 filled G 3-4. S else R filled G 5ANS. S S

S XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Xad+ance the initial statematri& through time Xnumber of times to run the model periodsP-:0E Xthe rate of idiosyncratic or random changes in the trader's position idioP-E.801 Xchange the random seed each time running this code set.seed? as.integer??as.double?Sys.time?@@W8EEEOSys.getpid?@@ 22 9]:8@ @ XinitialiAe the price matri& pricesP-matri&?E,8,periodsO8@ initialpriceP-8EE pricesT8UP-initialprice Xthe initial riskfactor gi+es an indication on how trader's mimic other traders beha+iour Xthe higher the riskfactor, the more mimicry by traders ?ma& +alue of riskfactor G 8.;0@ riskfactorP-E.1 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Xrun the model for ?i in 87periods@R Xcalculate the total net position of all traders at the beginning of the period initialsumP-sum?statematri&@ tempmatri&P-statematri& for ?/ in 97?dimone-8@@R for ?k in 97?dimtwo-8@@R Xfirst change the boarders of the grid Xnow change the internal grid randomprobP-runif?8,E.E,8.E@ if ?randomprob P idio@ R statematri&T/,kUP-sample?-878,8@ S else R Xanalogous to the $amiltonian. the mimicy riskfactor effects this +alue statematri&T/,kUP-round?riskfactorWsum?tempmatri&T?/-8@,?k@U,tempmatri&T?/O8@,?k@U,tempmatri&T?/@,?k-8@U,tempmatri&T?/@,?kO8@U@C;@ S S S Xfind the net change in the position of all traders changeP-?sum?statematri&@-initialsum@WpricesTiUC?dimoneWdimtwo@ Xuse this change to find the new price pricesTiO8UP-pricesTiUOchange Xad/ust the riskfactor - a ratio of the number of current longsCshorts in the market riskfactorP-count?8,statematri&,dimone,dimtwo@Ccount?-8,statematri&,dimone,dimtwo@ if ?riskfactor^8.;0@ R riskfactorP-8.;0 S finalpriceTpUP-pricesTlength?prices@U S mean?finalprice@ finalpricesP-as.+ector?finalprice@ +ar?finalprices@ library?moments@ skewness?finalprices@ kurtosis?finalprices@ quantile?finalprices,probsGc?E.EE8,E.E8,E.E1,E.91,.E1,8@@ hist?finalprices, breaks G 9E@